L16_Asymmetric Information & Agency Theory PDF

Introduction Managers and Stockholders Stockholders and Bondholders Corporate Governance Principles of Finance Lecture 16: Asymmetric information & Agency theory (CWS ch. 12, section B & C) Rikke Sejer Nielsen...

Introduction Managers and Stockholders Stockholders and Bondholders Corporate Governance Principles of Finance Lecture 16: Asymmetric information & Agency theory (CWS ch. 12, section B & C) Rikke Sejer Nielsen 1 / 24  Introduction Managers and Stockholders Stockholders and Bondholders Corporate Governance Introduction A firm using external financing: ⇒ Ownership and management are separated ⇒ Corporate decisions are made by managers (agents) on behalf of the firm’s capital suppliers (principals). Advantages: Managers generally more skilled to run the firm Impossible for many shareholders to run the firm together on a daily basis. Ownership can change without affecting the company’s operations Disadvantages of separation of ownership and management: ⇒ Agency problems (conflicts) arising from asymmetric information i.e. stockholders and bondholders do not have same detailed information as the management. 2 / 24  Introduction Managers and Stockholders Stockholders and Bondholders Corporate Governance Introduction 1 Conflicts between Managers and Stockholders ▶ Owners/shareholders and management have different interest and/or different risk-aversion. ▶ Management has the possibility to act against the stockholders’ interest. 2 Conflicts between Stockholders and bondholders ▶ when managers make decisions that benefit stockholders at the cost of bondholders. 3 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Conflict between Managers and Stockholders Main sources of conflict between Managers and Stockholders: 1 Choice of effort by managers 2 Manager has incentive to reduce overall risk of firm as his/her future job situation/wealth depends on it. 3 The manager and stockholders may have different horizons. 5 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Choice of effort by managers Based on Jensen and Meckling (1976) Settings: X = vector of activities (manager’s action/effort), F = manager’s nonpecuniary benefits of activities, C(X ) = Present value to firm of cost of activities, P(X ) = Present value to firm of productive benefits of activities, ⇒ Gain to firm of activities, X (⇒ Firm value): V (X ) = P(X ) − C(X ) ⇒ Value of the nonpecuniary benefits, F : F = V (X ∗ ) − V (X ), where X ∗ defines the optimal choice of managerial activities for shareholders. 6 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Firm value Firm value as a function of nonpecuniary benefits, F V (F ) = V (X ∗ ) − F ∂V (F ) ⇒ Slope = ∂F = −1 7 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Manager’s decision Manager’s utility of wealth: U(V , F ) ⇒ depends on firm value (V ) and nonpecuniary benefits (F ). Manager’s choice of effort/activity: max U(V , F ) X ⇒ Manager’s optimal choice of activity = Choice of F at the (V , F )-constraint that max. wealth of manager. 8 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Manager’s decision To examine how manager’s choice of effort is affected by conflict between management and stockholders: ⇒ Comparing two cases: Manager: 100% owner Partial owner Managerial ownership fraction 1 α ↓ ↓ Agency problem exists No Yes 9 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance When manager owns 100% If manager owns 100% of the firm’s equity, the manager’s wealth is W = V (F ) = V (X ∗ ) − F ← Optimal level of activity: (V*, F*) 10 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance When manager is partial owner, owning fraction α of firm If manager sell a fraction of (1 − α) of the firm for S: Manager’s wealth: W = S + αV (F ) = S + α(V (X ∗ ) − F ) Manager’s cost of consuming one additional F is α ( ∂W ∂F = −α) ⇒ Manager has incentive to increase F. Increasing F will hurt outside investors as the firm value decreases in F ⇒ Outside investors are willing to pay S < (1 − α)V ∗ Outside investors will pay S that ensures no immediate loss after buying ▶ Zero-sum game between manager (seller) and outside investors (buyers) ⇒ Manager: no gain from selling shares W (100% ownership) = W (partial ownership) ⇔ V (F ) = S + αV (F ) ⇔ S = (1 − α)V (F ) 11 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance When manager is partial owner, owning fraction α of firm Manager incurs a welfare loss (U1 < U2 ) due to agency problems Agency cost = V ∗ − V ′ 12 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Conflict between Managers and Stockholders Main sources of conflict between Managers and Stockholders: 1 Choice of effort by managers 2 Manager has incentive to reduce overall risk of firm as his/her future job situation/wealth depends on it. ▶ Risky projects increases likelihood of bad results ⇒ Increases manager’s chance of loosing job. ▶ Manager may have incentive to ignore value-adding projects if they are too risky, against interest of shareholders. 3 The manager and stockholders may have different horizons. ▶ Firm’s life is infinite, ▶ Manager’s employment limited by their tenure with the firm, ▶ Manager may ignore cash flows occurring after their horizon, against the interest of shareholders. ⇒ Underinvestment 13 / 24  Introduction Choice of effort Managers and Stockholders Other conflicts Stockholders and Bondholders Agency costs Corporate Governance Agency costs Agency costs are the costs associated with agency problems: ⇒ Loss in firm value due to agency problems. Direct agency costs ▶ Costs related to goods that only benefits the management (luxury goods). ▶ Cost to minimize agency problem: ∗ Costs of constructing managerial compensation contracts ∗ Monitoring costs Indirect agency costs ▶ Lower issuing prices of equity. ▶ Cost related to the management ignoring value-adding investment. ⇒ Financing using outside equity ⇒ Agency problems ↑ ⇒ Agency costs ↑ ⇒ Equity financing less attractive due to agency problems! 14 / 24  Dividend payout Introduction Claim dilution Managers and Stockholders Asset substitution Stockholders and Bondholders Underinvestment Corporate Governance Agency costs Conflicts between Stockholders and Bondholders Main sources of conflict between Stockholders and Bondholders: 1 Dividend payout 2 Claim dilution 3 Asset substitution 4 Underinvestment 16 / 24  Dividend payout Introduction Claim dilution Managers and Stockholders Asset substitution Stockholders and Bondholders Underinvestment Corporate Governance Agency costs Dividend payout Agency problem arises between stockholders and bondholders, when Manager unexpectedly increases dividends, financed by reducing assets or panned investments. Problem, if increased dividends are ▶ costly to bondholders: Increases debt risk and thereby reduce debt value ▶ while beneficial to stockholders: Increases equity value Example 1 on the board: A firm has assets with a value of $220 today: Assets in place Value today Expected return in one period (1) Cash $20 0% 20% return with prob. 50% (2) Risky project $200 -10% return with prob. 50% Risk-free debt maturing in one period: Face Value = $200. No dividend payouts are planned. 17 / 24  Dividend payout Introduction Claim dilution Managers and Stockholders Asset substitution Stockholders and Bondholders Underinvestment Corporate Governance Agency costs Claim dilution Agency problem arises between stockholders and bondholders, when Manager issues new debt with same priority or higher than existing debt ▶ Priority of debt: Debt with higher priority is repaid first! Problem, if the firm doesn’t have assets to cover promised debt payments ▶ Existing bondholders then have to share existing claims with new debt holders. ▶ costly to bondholders: Value of debt of existing bondholders is reduced. Example 2 on the board: A firm with: ▶ Firm value of assets, V ▶ Equity, E ▶ Risky debt = one issue of zero-coupon debt with ∗ Face Value of D, ∗ Maturity T i.e. only one debt payment, D, at time T. 18 / 24  Dividend payout Introduction Claim dilution Managers and Stockholders Asset substitution Stockholders and Bondholders Underinvestment Corporate Governance Agency costs Asset substitution Agency problem arises between stockholders and bondholders, when Manager decides to substitute a high-risk project for a low-risk project ▶ costly to bondholders: Increases debt risk and thereby reduce debt value ▶ while beneficial to stockholders: Increases equity value Examples on the board 19 / 24  Dividend payout Introduction Claim dilution Managers and Stockholders Asset substitution Stockholders and Bondholders Underinvestment Corporate Governance Agency costs Underinvestment Agency problem arises between stockholders and bondholders, when Managers ignore positive NPV projects (underinvest) in cases, where the projects only benefits the bondholders (not the stockholders). ▶ costly to bondholders: Underinvestment causes opportunity loss for bondholders Example on the board 20 / 24  Dividend payout Introduction Claim dilution Managers and Stockholders Asset substitution Stockholders and Bondholders Underinvestment Corporate Governance Agency costs Agency costs Agency costs are the costs associated with agency problems: ⇒ Loss in firm value due to agency problems. Direct agency costs ▶ Cost to minimize agency problems: ∗ Costs of debt contracting (e.g. including debt covenants to limit the actions of managers). ∗ Monitoring costs Indirect agency costs ▶ Lower issuing prices of bonds/higher coupon rates ▶ Cost related to the management ignoring value-adding investment. ⇒ Debt Financing ⇒ Agency problems ↑ ⇒ Agency costs ↑ ⇒ Debt financing less attractive due to agency problems! 21 / 24  Introduction Managers and Stockholders Stockholders and Bondholders Corporate Governance Corporate Governance Processes, practices etc. to support value-creating and responsible management Primarily focus on minimizing Agency problems 1 Minimize difference between manager’s and stockholders’/bondholders’ interests. 2 Reduce informational asymmetry. Examples of Corporate Governance: ▶ Create loyalty towards common goal ▶ Internal controls and procedures ▶ Constructing managerial compensation contracts to ensures the management’s incentive to max. market value of firm/shares. ∗ Compensation based on stock-prices or paid out as shares/optionshares ∗ Compensated by getting a fraction of the profit. Principles of corporate governance: ▶ EU company law rules ▶ OECD ”Principles of Corporate Governance” 23 / 24  Introduction Managers and Stockholders Stockholders and Bondholders Corporate Governance References CWS ch. 12, section B and C 24 / 24